Business and management

The proposed merger of BAE and EADS

Kaputt

THE challenge was always going to be getting the politics right. But when Britain’s BAE Systems, Europe’s biggest defence firm, and EADS, the Franco-German maker of Airbus civil jets and the owner of some smaller defence businesses, announced their intention to merge a month ago, managers of both firms were optimistic. They gushed about stars being aligned and the encouragement they had been given by the French, German and British governments.

Their optimism was misplaced. The deal died on October 10th, the date set by London’s Takeover Panel for the two companies to declare their intentions. They had three options: pressing ahead, throwing in the towel or asking for another couple of weeks to try and straighten out the politics. With a huge sense of regret on both sides, the decision was taken to call the whole thing off. It had hit an immovable object in the shape of Germany’s chancellor, Angela Merkel.

That came as a complete surprise to EADS and its German boss, Tom Enders. Few people have more experience or better “fingertips”—his expression—for understanding the politics of Europe’s defence and aerospace industry. A former paratrooper, Mr Enders has moved seamlessly between academia, politics and business. He thought he could use those fingertips to find a way of getting the politics out of EADS and turning it into a “normal” business. No such luck.

Four years ago, working closely with his predecessor at EADS, Louis Gallois, Mr Enders helped set out a long-term strategy for EADS: to build up the defence side of the business, which had become overshadowed by Airbus; to outsource more of its operations; to make a bigger splash in America; and to reduce the stakes held by the meddlesome French and German governments with the aim of getting rid of their dysfunctional shareholder pact. Merging with BAE would have helped EADS do all of the above: the British firm clocks up 40% of its sales in America, selling such things as armoured vehicles to the Pentagon.

From BAE’s point of view, too, a merger made sense. With the winding down of the wars in Iraq and Afghanistan, it faces a future of shrinking defence budgets. Marrying EADS would have given it a way back into civil aviation and a titanium balance-sheet, thanks to Airbus’s €486 billion ($626 billion) order book.

The managers of the two companies knew each other and got on well. They rapidly agreed on a 60/40 split of shareholding in EADS’s favour. They also knew, however, that unless the three governments played ball, the game would quickly be over. For the deal to make sense, the French and the Germans had to be willing to surrender enough influence to convince the Pentagon and Congress that the special security agreement given to BAE’s American subsidiary whould not be jeopardised. The British, the French and the Germans would all get a takeover-blocking “special share”, but the latter two would have to allow their stakes (both direct and held by proxies) to be reduced to the 9% level deemed acceptable by the British and the Americans. The French were expected to cause trouble, but with some quibbling, they and the British were keen for the deal to go ahead.

Merkel says nein

However, in the past few days it became clear that the opposition was coming from the Germans. According to someone close to the discussions, the Germans initially assumed they could hide behind the French. When the French looked like supporting the deal, the German negotiators were taken aback. They first insisted on the German government having the same 9% direct stake as the French had agreed to. then the German government (which currently holds most of its 22.5% interest through Daimler, a carmaker) would take a similar direct stake. No problem, said the French and the British. The next demand was for the corporate headquarters to be in Munich rather than Toulouse (the defence business was to have been based in London). “We can work something out,” came the reply. Yet on October 9th Mrs Merkel rang the French president, François Hollande, to tell him that she intended to veto the deal.

Where does that leave the two firms? The blow for EADS is not quite as great as it is for BAE—its main Airbus business is still growing strongly. But Mr Enders’s strategy is now doomed. He has been reminded how hard it is to build a more rational European defence industry. The experience will have seared him.

BAE’s position is trickier. It is a well-managed firm with good long-term prospects thanks to its uniquely international portfolio. But the medium term looks bleak, with falling sales in its core markets. Its scope to diversify or make acquisitions is limited by a weak balance-sheet and a £5 billion ($8 billion) pension deficit. Guy Anderson of IHS Jane's, a defence-research firm, says it will most likely continue to sell non-core assets. However, because BAE is now regarded by some as a company in play, Mr Anderson says it may need to do something bigger.

A large American defence contractor could bid for BAE. However, the British government might use its special share to prevent a deal that would leave it with far less influence than the tie-up with EADS would have done. None of the choices open to BAE looks as good as the one that has just vanished in a puff of smoke.

I'm disappointed of the prestigious magazine "THE ECONOMIST" The article is written from a narrow British perspective.

Why should France and Germany allow that their defense HQ moves to the UK? Imagine the British defense HQ moves too Berlin or Paris.. How would the government react? Plus a deal of 60/40?
Please.. EADS is financially and strategically way more powerful than BAE.

Germany did again very well! One of the reasons why it is the by far the strongest economy in Europe!

The collapse of the proposed merger between BAE Systems and EADS will shift the focus now to smaller deals among global weapons as defence companies strive to keep revenue streams rising in the face of cuts to military defence budgets in America and Europe.

Analysts do not foresee mega-deals of this sort on the horizon for now – the proposed contract between Britain, France and Germany on the BAE-EADS deal was said to be worth around $45 billion. The failure shows how easily a deal of that scale can be derailed by the competing interests of different countries, despite the commercial sense it would have made.

Major defence companies will likely focus on partnering with smaller players such as Rockwell Collins, L-3 Communications Holdings Inc, SAIC Inc or ITT Exelis and Harris Corporation. American companies don’t seem that eager to grow in defence – perhaps in an attempt to secure their base – while many overseas companies have been chastened in watching the BAE-EADS deal falter.

The scope of consolidation in the defence industry largely hinges on how Congress deals with the $1.2 billion in mandatory budget cuts to start in 2013. Half of those cuts are for defence and, given that, one would have to assume that mergers and acquisitions will remain slow if not a low political priority.

Worldwide aerospace and defence deals total just $5 billion so far in 2012, compared with $27.5 billion in 2011.

The collaborative effort by BAE and EADS to create the world’s biggest aerospace and defence group underscores the effect of shrinking markets on big weapons makers. Other major companies are scrambling to move into adjacent civilian or commercial markets or in finding smaller takeover targets to keep revenues growing. BAE’s American unit is looking for possible mergers in the areas of cyber, intelligence, security, and within the electronics and international side of businesses.

The U.S. Department of Defence has discouraged mergers among its prime contractors, but has stated it is fully anticipating takeover consortiums among second- and third-tier suppliers, given the expected decline in defence spending in the coming years.

Always amusing to see some Americans claiming to be paying good money to give Europe "free protection". Protecting us against whom: Iran? Israel? North Korea? Cuba? The reason America has military bases and missile sites all around the world (including in Europe) is as a deterent against any attack on America -- by Iran, Cuba, etc.

I agree. They are using Europe's security as an excuse for their financially irresponsible military spending and vast military complex. But the truth is: Europe is meanwhile a mere hub for geostrategic power projection to the middle east, but not a zone that has an immediate threat that it cannot handle itself. So it is to a large degree self-interest, with some mutual benefits.

What the defense industry in the US probably is not interested in: if you push Europe towards a 100% self-reliance, they will align their defense policies finally and spend their combined 320 bn less on overpriced American hardware and more money on self-developed capabilities, thereby also creating a challenge to US contractors in the defense equipment markets worldwide. Europeans did challenge their large US rival in civil aviation, why not elsewhere.

There is an interesting US poll about that topic. The views in the comment section are pretty interesting.

Would like to add Mars. Its red surface is proof that it is governed by hordes of malicious scapegoating communists. The rover's true mission is not find water but WMDs. We all look forward to the carpet bombing, once we get confirmation.

Don't be hard on Swatchland. Besides legally stealing, which still has required some intellectual skills, they practically showed the world how you do not need huge armies and expensive defense systems to avoid war and invasion.

And regardless what the Swiss like to boast about their perfect representative democracy, EU law has heavily impacted on their normative framework. Soon they will have to abide to some obscure EU law regulating the size and texture of confettis to throw, on account of safety and possibly environmental grounds. You must have some sympathy for the formerly-isolated-come-global.

Don't worry, the Swiss are nice people who are polite, clean, precise, surprisingly polyglot and are world leaders in individual happiness so they can't be that wrong and have my deepest respect. Yet, the most significant of all traits is that they really stick to rules. Where it gets problematic is if they stick to wrong rules such as the Bankgeheimnis (bank account secrecy). Criticize that and you got a werewulf that you need to fix somehow before you get bitten. I am still puzzled how the banking industry lobbied the whole thing into a matter of national interest over decades (and how long the rest of the world acccepted it). But apart from that I actually do admire the advantage of their representative democracy and understand why they are so fond of it. I clearly remember when they had a referendum at the beginning of the 2000s and voted to keep nuclear energy. A thing I would have wished for in Germany. Actually some elements of Swiss democracy like referendums could be a very good example of how the EU should do it in order to keep EU citizens connected to what's happening at the top and it would increase legitimacy. It makes people stop complaining when they had a true say on topics that are affecting their daily lives, even if they "lose" their referendum. Much better than just a cross in a circle every 4 to 5 years.